ROYALTY FINANCING

Royalty financing is a relatively new concept that offers an alternative
to regular debt financing (loans and trade credit) and equity financing
(venture capital and stock sales). In a royalty financing arrangement, a
small business would receive a specific amount of funds from an investor
or group of investors. This money might be put toward launching a new
product or expanding the company's marketing efforts. In exchange,
the investors would receive a percentage of the company's future
revenues over a certain period of time, up to a specific amount. The
investment can be considered an "advance" to the company,
and the periodic percentage payments can be considered
"royalties" to the investors.

Royalty financing arrangements offer a number of advantages to small
businesses. Compared to equity financing, royalty financing enables
entrepreneurs to obtain capital without giving up a significant ownership
position in the company to outside investors. The founders of the company
are thus able to preserve their equity position, which may help motivate
them toward continued success. In addition, royalty financing
arrangements—since they most resemble loans—are not subject
to state and federal securities laws, as some equity financing deals are.
Thus the company is able to save the time and money it might otherwise
devote to complex filings and legal fees. Royalty financing also increases
a company's ability to structure deals with individual investors,
who might be attracted to the idea of receiving a monthly or quarterly
yield over the life of their investment. In contrast, equity financing
arrangements often show no yield until the stock is sold.

Compared to debt financing, royalty financing provides more convenient
payback terms and less severe penalties for default. In addition, the
infusion of cash may help the company increase sales, which may make it a
better candidate to obtain more financing later. Finally, royalty
financing enables a small business to keep its options open for later
financing rounds. In contrast, a company that incurs significant debt or
sells a great deal of equity in its early stages may find it difficult to
attract investment later.

DETAILS OF ROYALTY FINANCING

As an example, suppose that a small business obtains an
"advance" of $100,000 against future sales from individual
investors or an economic development organization. In exchange, the
investors would receive 3 percent of the company's total sales for
a 10 year period, to a maximum of $300,000. If the company repaid the
investment over 10 years, then the investors would earn a compound annual
return of 11.6 percent. However, if the investors reached their maximum
royalties of $300,000 in half that time, the initial investment would
yield an annual return of 24.5 percent.

A small business interested in royalty financing may be able to negotiate
a grace period, so that royalties will not begin to accrue for a quarter
or more following the close of the deal. It may also be possible to
establish a lag between the time revenues are realized by the company and
the time royalties are paid to investors. This sort of arrangement can
give the small business time to put the capital to work and increase sales
before paying a percentage of sales as royalties. In most cases, these
arrangements are acceptable to investors since they still offer a better
deal than most equity financing arrangements, which only pay when the
stock is sold.

In an article for
Entrepreneur,
David R. Evanson noted that royalty financing may tend to work best for
small businesses that have some elasticity in pricing,
so that they can raise prices to cover the percentage of royalties
without losing customers. Royalty financing is also suitable for companies
for which increased marketing efforts have an immediate impact on sales.
However, royalty financing may not be a good option for companies with
very tight profit margins. In summary, the capital gained through royalty
financing can enable a fledgling business to launch a new product or
expand its marketing efforts without having to give up too much equity in
the early stages. In royalty financing, investors own a piece of the
company's revenue stream rather than a piece of the company itself.